Moral Hazard, portfolio allocation, and asset returns for thrift institutions

Abstract

This article examines the earnings performance of nontraditional assets allowed to thrifts since the early 1980s. It uses the statistical cost accounting methodology developed by Hester and Zoellner to estimate average returns on thrift portfolio investments for the years ending June 30,1987 and June 30, 1988. Results show that average returns on land loans, service corporation investment, real estate investment, and commercial loans were significantly lower than returns on more traditional assets. The results are far more pronounced at capital deficient institutions, lending support to the hypothesis that they used nontraditional investments as a means of exploiting the deposit insurance system. Returns on nontraditional assets are significantly affected by geographic factors, even for well capitalized institutions. The article concludes with an evaluation of the reimposition of portfolio restrictions on thrifts by the Financial Institutions Reform, Recovery, and Enforcement Act of 1989.

Risk taking and failure in de novo savings and loans in the 1980s

“…These findings are consistent with other studies of thrift failures that have found higher proportions of nontraditional assets in failed institutions (White, 1991;McKenzie, Cole, and Brown, 1992;Cole, McKenzie, and White, 1991). Expansion into less familiar areas such as land loans, non-mortgage loans, and subsidiary service corporation activity did not produce the diversification results which were anticipated and desired by the regulatory agencies.…”

“…We interpret this evidence of economic stress as support for the economic decline hypothesis as a contributing cause of the S&L collapse. It is also consistent with similar findings provided by McKenzie, Cole, and Brown (1992). l°…”

“…evidence of above-average investments in nontraditional loans in failed institutions. McKenzie, Cole, and Brown (1992) provide evidence supporting the economic decline or exogenous shock hypotheses.…”

“…Rather, they led to increased risk and lower returns. This is further documented for all FSLIC-insured institutions by McKenzie, Cole, and Brown (1992). Lindley, Verbrugge, McNulty, and Gup (1992) document that de novo institutions with riskier asset portfolios had lower realized returns.…”

The 'Risk-Adjusted' Price-Concentration Relationship in Banking

“…This is because market concentration may be negatively related to risk (Rhoades and Rutz 1982); and, risk (ceteris paribus) may be positively related to consumer deposit rates. Additionally, this risk-deposit rate relationship may have been accentuated by the moral hazard problems of flat-rate deposit insurance as discussed in Barth and Bradley (1989), Buser, Chen, and Kane (1981), and McKenzie, Cole, and Brown (1992). The critical linkages, however, are between risk and market structure.…”